In this new edition of Fund in Five, we talk to Stephen Snowden, head of fixed income at Artemis, and co-fund manager of the Artemis Corporate Bond Fund, to look at the portfolio from five angles and understand why this is a good time to invest in the asset class.

Now, another turn in truths may be occurring for the asset class, as the risk factors of corporate and government bonds begin to shift. According to Shaniel Ramjee (pictured), co-head of multi asset at Pictet Asset Management, bonds issued by corporates are currently “paradoxically safer”.

“A lot of corporates have managed their balance sheets very well. They’re not as leveraged as they have been in the past, and therefore the spreads that they trade out over and above governments are low, but they might stay low for longer periods of time because of the nature of a much more diversified opportunity set,” Ramjee said.

“These corporates aren’t as indebted as the governments, and by and large, we see less and less corporate bonds being issued versus government bonds being issued every week. The supply and demand of these two asset classes is different. So I think paradoxically, we’re in a period where government bonds are riskier than usual, and actually corporate bonds can be less risky than usual. And I think that’s an interesting difference today than we might have seen in years gone by.”

While the issuance of some corporate bonds has caused a bidding war among investors, government bonds from typically desired countries such as the US and UK are all too available for investors as they attempt to stimulate their economies.

Other countries with typically stable markets, like France, have been rocked by political uncertainty. French 10-year government bond yields currently sit above 3.4%, almost a percentage point above the 2.6% levels of last January. French yields now sit in line with the government bond yields in Greece.

See also: What does the gilt yield spike mean for UK bond prospects?

“Ultimately, these governments have borrowed a lot of money. They’re highly leveraged, and unfortunately, like we see in the UK, the propensity for these governments to want to come and borrow is very high. So the risk is that the credit worthiness of those countries are deteriorating, and no one wants to really think about reducing spending,” Ramjee said.

As of October 2024, the estimated UK government bond issuance for the 2024/25 fiscal year was £294bn following an expansion by Rachel Reeves during the Autumn Budget.

When markets opened on the day of the budget, the yield of a UK 10-year gilt sat at 4.27. As of market close on 6 January, the yield is 4.61. Year on year, yield has increased by 23%. In the last week, 30-year gilt yields hit their highest level in near three decades.

To Ramjee, this could be the beginning of a larger problem if the economy is not able to grow under the new fiscal policies.

“Particularly within the UK, we’re at a really high tax burden. But on top of that, what’s happening is that if you don’t grow the economy, the risk is that the government has to come back for more taxes in the coming years. And I think that’s the other element that markets are worried about, especially in UK gilts, is that the tax rises have not finished,” Ramjee said.

“That’s why it’s so important to have growth policies along with any other tax rises, because if you don’t have them, then the market will get more concerned that you’re not doing anything to actually to grow the economy. That’s what’s been weighing on the gilt markets to date.”

See also: Will bond yields stay higher for longer?

As the asset class shifts, Ramjee said its use in portfolio’s becomes less clear: government bonds in particular were traditionally seen not just as a diversifier against equities, but a way to manage levels of risk. Now, Ramjee said it can not be relied on as heavily for either of those reasons.

“Government bonds provided a good stabilizer in a portfolio. They provided income, but they also provided a diversifying effect. When equities went down, bonds went up, and that helped the overall balance of a portfolio.

“What we see now as those debt levels have risen, and as the risk in those government bonds has risen is that the correlations are no longer as good for multi-asset portfolios, so you can’t rely on them as much as you could before to give you that diversification. And I think that is worrying from a multi asset standpoint, that you have to rely on different types of assets to diversify you.”

Investors have piled into cash and money market funds following the meteoric rise in rates from 2022. However, with rates expected to fall soon investors may want to consider putting some of that cash exposure elsewhere, and we think a natural first step is short dated high quality corporate bonds and then all-maturity corporate bonds once the curve dis-inverts.

Investors added to cash as rates rose

Assets in money market funds are over $6tn, having doubled from the asset level pre-pandemic, with Fidelity’s money market funds seeing strong asset growth too. This makes sense, for investors used to almost zero rates for the decade following the Global Financial Crisis the prospect of >5% yields from low-risk cash investments was, and is, attractive. As our money market team attest here, the case for cash remains strong. There will always be a need for cash, particularly for those investors prioritising liquidity and capital preservation. However, some investors may be allocating to cash for the prospect of outperformance versus other asset classes. While this was the right call in recent years (cash outperformed most asset classes in 2022, for example), those investors might want to consider corporate bonds looking ahead.

Interest rate cuts are here

The negative drivers of bond returns – inflation and interest rate hikes – are abating which sets fixed income up well for the period ahead. Inflation is now at, or close to, target which has given the green light for the major central banks to start cutting interest rates. The Bank of England has cut once already and is very likely to go again in early November, while the Federal Reserve and European Central Bank have also started to ease monetary policy.

Cash offers an attractive yield to maturity

Ahead of a cutting cycle cash rates are elevated because, like today, they tend to have followed a series of rate hikes which optically makes cash look attractive from a forward-looking return standpoint. As figure 1 shows, with rates still elevated investors can generate an attractive yield to maturity from cash, which is similar to corporate bonds.

Figure 1: Yield to maturity is similar across cash and corporates bonds

Source: Fidelity International, Bloomberg, 14 October 2024. 1-5yr Corporate Bonds = ICE BofA 1-5 Year Eurosterling Index; All Maturity Corporate Bonds = ICE BofA Euro-Sterling Index; Government Bonds = ICE BofA UK Gilt Index; High Yield Bonds = ICE BofA Sterling High Yield Index; Sterling Cash = ICE BofA Sterling 1-Month Deposit Bid Rate Constant Maturity Index.

With rates expected to fall, it might be time to consider corporate bonds

So, why bother with corporate bonds if you can get more-or-less the same level of yield from cash? Firstly, cash is more exposed to reinvestment risk. Reinvestment risk refers to the risk that investors are unable to reinvest cashflows, such as coupons or principal, at a rate comparable to the current rate of return. As rates fall, cash and money market instruments are more exposed to this risk given these securities often have maturities measured in days (rather than years). This means cash yields (and returns) more closely follow central bank rates lower relative to bonds.

On the flipside, fixed income securities have a fixed income for a longer period of time and the value of those cash flows rises as interest rates fall. This impact is known as duration risk, a measure of the sensitivity of the price of a debt instrument to a change in interest rates (yields fall, prices rise). So, if central banks are cutting rates, time to add as much duration as possible? Not quite, for two reasons. Firstly, markets tend to price in cuts before they happen and so the extent of the rally in bonds during a cutting cycle depends on how many cuts were already priced in. Secondly, as we have highlighted before, if the yield curve is inverted, like today, then short dated bonds can outperform longer dated bonds as the curve normalises despite having less duration risk. In these unique circumstances your position on the curve can be a more powerful driver of return than the absolute level of duration. The curve inversion makes us particularly constructive on 1-5yr corporate bonds.

Finally, through active management, we can pick those bonds with a more attractive level of yield per unit of risk to generate an excess yield over cash and comparable indices. For example, while the 1-5yr corporate bond market offers a yield of 4.9%, the yield to maturity on Fidelity Short Dated Corporate Bond (Fidelity’s active 1-5yr corporate bond fund) is 6.5%, while Fidelity Sustainable MoneyBuilder Income and Fidelity Sterling Corporate Bond (Fidelity’s two active all maturity corporate bond funds) offer a yield to maturity of 5.6% each versus the all maturity corporate bond market at 5.2%.

History suggests high quality bonds tend to perform well versus cash in cutting cycles

If history is a useful guide it seems unlikely that cash will outperform safer bond assets as interest rates fall, but it may outperform high yield and equities. Bonds offer an attractive proposition as a first step back in, and particularly short dated corporate bonds for the more conservative investor. This is because bonds tend to perform well as central banks cut interest rates and – with the front end of the curve more sensitive to interest rate policy, and yield curves inverted – short dated bonds could stand to benefit more in the earlier phases of the cutting cycle.

Corporate bonds offer a relatively safe option versus cash over the longer term

Investors with high cash allocations tend to be risk averse, so what about a worst-case outcome over 3 and 5 years? As figure 2 shows, over a 3yr holding period, the worst excess return over cash from 1-5yr corporate bonds in the cutting cycles we identified was +3.6%, when cash delivered +19.2% returns while 1-5yr corporate bonds delivered +22.8% returns (October 1998). In the other 3 cutting cycles, 1-5yr corporate bonds outperformed cash by even more over 3yrs (with this outperformance ranging from +5.4% to +11.8%). For high yield and equities, the worst-case outcomes were -19.8% and -37.3% respectively over 3yrs. It is also notable that the FTSE 100 was down in absolute terms over 3yrs in 3 of the 4 cutting cycles we identified. The average 3yr return from the FTSE 100 versus cash in the four cases we identity is -7.4%, this is because central banks tend to cut into weakness to stimulate the economy. Over 5yrs following a cutting cycle, all maturity corporate bonds stand out as a relatively safe option based on history with the worst-case excess return over cash at +14.2%. This was in the 5yrs following December 1995 when cash delivered +36.7% return versus all maturity corporate bonds at +50.9% (December 1995). All maturity government bonds come in second, largely due to its higher duration profile (at 9.1yrs) relative to 1-5yr corporate bonds (at 2.5yrs).

For the risk averse investor looking to outperform cash in the medium term we think corporate bonds are set up well as the BoE cuts interest rates. Furthermore, with the yield curve inverted, 1-5yr corporate bonds may be an attractive option over 3yrs. Over the longer term (5yrs), all-maturity corporate bonds standout well as the curve normalises and investors can once again benefit from higher yields for taking more risk via longer dated bonds.

Figure 2: Worst excess return over cash during BoE cutting cycles over 3yrs and 5yrs suggest corporate bonds look attractive for risk averse investors

Source: Fidelity International, Bloomberg, October 2024. 1-5yr Corporate Bonds = ICE BofA 1-5 Year Eurosterling Index; All Maturity Corporate Bonds = ICE BofA Euro-Sterling Index; Government Bonds = ICE BofA UK Gilt Index; High Yield Corporate Bonds = ICE BofA US High Yield Index used for the first cutting cycle, while ICE BofA Global High Yield Index (GBP Hedged) was used for the remaining cycles; Equities = FTSE 100. Cash rate was ICE BofA British Pound 6-Month Deposit Bid Rate Constant Maturity Index for the first cutting cycle and then the ICE BofA Sterling 1-Month Deposit Bid Rate Constant Maturity Index for the remaining 3. Uses 4 Bank of England interest rate cutting cycles between 1995 and 2024, starting in December 1995, October 1998, February 2001 and December 2007 respectively. Returns start 3-months prior to first cut to incorporate the impact of expectations.

What if rates don’t fall much? A relatively large yield move is needed to lose a years’ worth of carry

What is the risk to this view? If rates are not cut by as much as expected, or the BoE start to hike. The likelihood of hikes seems low, but we cannot discount this, or a continued hold. The good news for corporate bond investors is that yields have risen materially in the last 2yrs, meaning the starting point for return from corporate bonds is attractive and it therefore takes a relatively large yield move to ‘wipe out’ a years’ worth of carry. This is known as the breakeven rate (calculated as yield to maturity divided by interest rate duration). As figure 3 shows, 1-5yr corporate bonds have a breakeven rate of 2.0%, meaning yields need to rise by 2% before you lose a years’ worth of carry. 3yrs ago this breakeven rate was 0.3%. The breakeven rate for 1-5yr corporate bonds compares favourably to all maturity corporate bonds and all maturity Gilts, at 0.9% and 0.4% respectively. On balance, short dated corporate bonds seem like an attractive risk-adjusted option.

Figure 3: Wipeout yield, the yield move required to lose a years’ worth of carry

Source: Fidelity International, Bloomberg, 14 October March 2024. 1-5yr Corporate Bonds = ICE BofA 1-5 Year Eurosterling Index; All Maturity Corporate Bonds = ICE BofA Euro-Sterling Index; Government Bonds = ICE BofA UK Gilt Index. Wipeout yield is worked out as yield to maturity divided by interest rate duration and is a measure of the yield move required to ‘Wipeout’ a years’ worth of carry.

Better off in government bonds?

So why not go for government bonds as the BoE starts to cut? Firstly, we find that 1-5yr corporate bonds outperform government bonds on average in the first year following cuts and, as figure 2 shows, the worst-case outcomes are better in 1-5yr corporate bonds over 3yrs, while more attractive in all maturity corporate bonds over 5yrs. Why? Because investors in corporate bonds benefit from the credit spread, the additional yield for lending to corporates over government bonds. The credit spread today is roughly 1%, providing an additional tailwind to performance. This is despite the all-maturity Gilt index having much more duration than both the 1-5yr and all maturity corporate bond indices, reaffirming the notion that position on the curve is important in a cutting cycle. The credit spread also provides a mild cushion against yield rises, which explains why the Wipeout yield is more attractive in corporate bonds over government bonds (see figure 3).

Perhaps it is time to put some of that cash into corporate bonds.

Fund returns versus index (net of fees)

Past performance is not a reliable indicator of future returns.

Source: Fidelity International, 30 September 2024. Performance reflects Fidelity Short Dated Corporate Bond Fund W Income Shares, Fidelity Sustainable MoneyBuilder Income Fund W Income Shares and Fidelity Sterling Corporate Bond Fund W Income Shares. Basis Bid-Bid with income reinvested in GBP.

IMPORTANT INFORMATION

This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity’s range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. FIPM: 8524

The circumstances of 2022 were extreme. Interest rates had been at unprecedented lows, and then rose incredibly fast. At sub-zero yields, bond markets had become vulnerable to a sophisticated version of pass the parcel, where instead of a present, the person left holding it would be left with a portfolio of underperforming debt.

To be clear, fixed income markets do not have the same vulnerabilities today. However, some concerns have started to emerge on valuations. There are question marks over whether government bond markets are pricing in too high a level of interest rate rises, and whether corporate bond spreads leave any margin for error.

See also: Small caps: Is it time for some UK cheer?

Looking at corporate bonds, Damir Bettini, fixed income portfolio manager at Capital Group, agreed that there are risks.

He said: “There is an ongoing vigorous debate in the market as to whether global corporate bonds are expensive or offer good value. Those that are making the case that the asset class is expensive points out that credit spreads are at multi-decade tight levels.”

He admits that current spread levels suggest a negligible chance of recession, adding: “If we get a reasonable-sized recession – something that is consumer-led, and impacts asset quality, there could be 100bps of spread widening.”

However, he said the greatest risks come in a stagflation scenario, where central banks need to raise rates because inflation takes off and there’s no growth. He believes this scenario looks unlikely and that’s why markets are generally taking a positive view. For him, the global economy appears resilient, with inflation falling and plenty of scope for central banks to cut rates even without a recession.

Bettini added: “Even if corporate bonds do look expensive at an aggregate level, it is a broad, deep asset class. We see a fair amount of dispersion across regions and across industries. The US is very expensive, while Europe has lots of interesting investment opportunities. The UK is currently sitting between US and Europe and we’re also finding good opportunities in Asia.”

Perhaps, most importantly, corporate bonds still offer an attractive yield. Dillon Lancaster, manager on the TwentyFour Dynamic Bond fund, said: “When yields are attractive and correlations are correct – ie a negative correlation between corporate and government bonds – fixed income markets usually behave very well. Our Dynamic Bond fund has a yield of 6.7%, and the average rating for our holdings is BBB+.” This combination of high yield and low risk is likely to keep investors interested in the near-term.

Government bonds

Government bonds are facing different pressures, but the biggest problems are appearing in the US market.

David Roberts, head of fixed income at Nedgroup Investments, said: “At the time of the recent US rate cut US 10-year Treasury bonds paid a yield of 3.65%. Thanks in part to stronger than forecast data, stronger perhaps than the Fed had anticipated, that yield actually increased to more than 4% by 6 October. Yields had already been rising for a couple of weeks prior to [Jerome] Powell cutting rates – markets priced too many cuts, were too worried about the jobs market and started to fret about post US election fiscal policy.”

Lancaster said post-election policy is a worry, with neither side appearing to care very much about whether the deficit keeps expanding.

See also: Investment trusts: Retail investor take up of private equity trusts remains low

He added: “The main thing for the market is not who is going to win, but the make-up of the Senate and House of Representatives. The market will breathe a sigh of relief if there is a split government. The US is the founding father of checks and balances in its system. If there are competing interests from Congress and the President, nothing gets done. The market wants gridlock because that might help bring the deficit under control.”

His view is that longer-dated US government bonds could be vulnerable to a sell-off if there is a Republican sweep. Trump’s tariffs could be inflationary and there would be worries over any interference with the independence of the Federal Reserve. In a split government, long-dated bond yields could fall, and under Harris, they would probably stay unchanged.

Mark Dowding, BlueBay CIO, RBC BlueBay Asset Management, is bearish on 30-year yields. He said: “Looser fiscal policy points to a need for term premia to increase on a structural basis, and we think fair value for the long end of the curve is likely to sit closer to 5%.” It is currently 4.4%.

Lancaster said there is an Armageddon scenario, where the US experiences a Liz Truss style meltdown in its bond market. It is worth noting that a significant chunk of US treasuries are bought by ‘unfriendly’ nations, such as China. However, he sees this extreme development as a remote possibility, and believes there is always likely to be a buyer for US treasuries.

Government bond markets elsewhere do not have the same political risks, nor do they have the same expectations on rate cuts built in, though an Armageddon scenario would sink all boats. Non-US governments cannot afford to take such a devil-may-care approach to their deficits. This is particularly notable in the UK, when government bond yields have proved sensitive to merest hint that Chancellor Reeves may change the debt calculations to support investment.

The overall picture is that bond markets are not cheap in aggregate, but there is considerable nuance beneath the surface, with different durations, regions and sectors offering different value. On core metrics such as income and diversification, fixed income still earns its place, but there are pitfalls, and the environment argues for selectivity.

See also: Are the negative flows from UK equity funds justified?

This article originally appeared in our sister publication, PA Adviser

In this Fund in Five, Ian Fishwick, lead manager of the Fidelity Sterling Corporate Bond Fund, discusses why falling interest rates, and an attractive starting level of yield, are increasing the investment case for the asset class.

In a research note published at the end of last month, following the US Federal Reserve’s decision to cut interest rates by 50 basis points, the team said this provides “a pivotal moment for markets as a whole”.

When it comes to fixed income in particular, it said the cut could “finally be a turning point” for bond investors who have dealt with “challenging, volatile market conditions for a number of years”.

There is no denying that the last two years have been tough for fixed income investors.

See also: Amundi introduces Article 8 global fixed income strategy

“The inflation experienced in 2022, coupled with the aggressive monetary policy that followed from central banks [including the Fed] created an incredibly difficult backdrop,” the team wrote. “Furthermore, volatility has continued to characterise the markets too, and has been exacerbated by investors expecting a rate cut far sooner than September 2024.

“In fact, interest rates remaining elevated, following the Fed’s aggressive rate-hiking cycle, has been one of the biggest issues for investors. Arguably, though, rates had to remain higher as inflation proved to be stubborn and resisted tightening measures made by the Fed.”

Therefore, the Square Mile’s research team said the Fed remained hawkish, leading to higher yields and higher coupons on bonds, while bond prices remained suppressed.

“Now, the pendulum seems to have swung for policymakers,” it said. “The risk for the Fed is no longer inflation, but a slowing economy. The rate cut could, therefore, be the key to unlocking returns many bondholders have been waiting for as when interest rates fall, bond yields typically decline as well, pushing bond prices higher.

“For those holding existing bonds, this is particularly beneficial as the value of their bonds rise in response to lower yields in the broader market.”

What’s more, the fact the US central bank is moving in line with broader market expectations gives “a clearer insight into the future”, the team said. While monetary policy decisions can be surprising and against consensus, Square Mile believe investors can now count on further interest rate cuts, which will continue to support bond prices.

Which bond funds are attractive?

Square Mile said there are “several” types of bonds funds that now look attractive. For instance, the team currently favours investment grade credit over government bonds, due to a favourable economic backdrop for company earnings.

Overall though, it prefers strategic bond funds, which are able to invest across a range of fixed income assets and rebalance portfolios depending on the top-down and bottom-up opportunity set.

See also: M&G selects Joe Sullivan-Bissett as fixed income investment director

“For many, the news of a rate cut should be promising especially for bondholders, given the rollercoaster ride of the last two years for fixed-income investors,” Square Mile concluded. “Bonds won’t just be used to mitigate risk in equities; they could also generate returns in themselves. 

“That being said… we still believe it’s vital to stay vigilant to risks too. After all, the Fed has cut its rate by more than many assumed, in response to weak economic data. Being flexible and taking a diversified approach will be essential to navigating any further tricky periods, as well as adjusting interest rate risk as required by market conditions.”

In this Fund in Five, Kris Atkinson, lead manager of the Fidelity Short Dated Corporate Bond Fund, discusses the factors in the market which are boosting the appeal for the asset class.

Which particular asset classes and strategies do you anticipate your intermediary clients focusing on for the remainder of 2024?

The key question for the second half of 2024 is not hard to frame. Should investors embrace the global soft economic landing narrative and add to equity risk, or is this the moment to step back and raise cash while sentiment is still high?

Persistent inflation means that interest rate cuts might be delayed as central banks try to finally squeeze inflation down to their preferred level of around 2%. This has caused bond yields to rise again and it also places a question mark over the outlook for some equities.

However, it’s by no means all bad news. Stronger economic growth is usually good for company earnings, and therefore good for equities and corporate bonds. To us, equities continue to be the most attractive asset class. Robust earnings and dividend growth, combined with the prospect of lower interest rates from mid-year, continue to be supportive, even after the rallies we have seen to date.

Corporate bonds appear attractive, but government bonds less so. A recent OECD report forecasts that debt issuance by 38 industrialised countries will rise by 12% to $15.8trn this year. This has been exceeded only once, in 2020, when governments were scrambling to support economies at the height of the pandemic. We are of the view that bond investors may start to demand even higher yields to compensate for the risks of holding government bonds.

Should end-investors – and, by association, asset managers – be thinking beyond equity and bond investments? Towards what?

Before looking beyond equities and bonds, it’s common sense to ensure that the core of the portfolio is genuinely fit for purpose. For long-term investors, insight into what is driving change in society is key. It is this that underlies our global thematic approach and gives us a lens to identify connections and opportunities that you could well miss by focusing on specific regions, sectors or investment styles such as growth or value.

See also: Track to the Future – with Trium Capital’s Donald Pepper

Beyond mainstream equities and bonds, we see an active role for alternative investments in a well-diversified portfolio, both from the perspective of enhancing returns and smoothing risk. We include a variety of alternative investments in our models, including income-earning assets such as infrastructure and renewable energy, defensive options such as low-volatility investment and trading strategies, and gold.

Having the ability to flex these as market and economic conditions change is crucial. For example, specialist trading strategies came into their own during the worst of the interest rate rises. More recently, the prospect of lower interest rates has increased the appeal of some income-earning alternatives with long-term cash flows.

To what extent do private assets and markets fit into your thinking? What are the current pros and cons for investors?

Deciding whether to allocate to private markets is not a straightforward decision. There is a much greater difference between gross and net returns in private markets than elsewhere, and investors need to decide whether the net results are worthwhile.

Given the considerable range of returns between managers, it’s crucial to be able to identify – and access – the best possible managers for your investment purposes. These are illiquid assets, with plenty of potential for investors to ‘marry in haste and repent at their leisure’. Investors should also consider how any ethical requirements might be met and monitored.

If one can manage the issues of manager selection, access, illiquidity, ethics and cost, it appears logical to us that long-term investors should consider private markets.

Opportunities for genuine diversification and for long-term growth from industries of the future are becoming scarcer in listed markets. If you wish to own an equity portfolio with similar overall risk, return, maturity and industry exposure characteristics to one of 20 years ago, today it would be made up of a mix of listed and unlisted investments.

Given client and regulatory pressure on charges, how is your business delivering value for money to intermediaries and end-clients?

As everyone knows, price is one thing and value is another. There is ongoing pressure on all fees, whether they be the costs of the underlying funds, DFM fees, platform fees and adviser fees which ultimately drive down the total cost of ownership for the underlying client. As long as the quality of the proposition and service is not impaired in this process, it has to be good for the end client. However, given that all of the component parts mentioned above are becoming increasingly commoditised, including the investment management in some cases, the differentiator has to be the service and support that we can offer intermediaries, equipping them with all the timely information that a client will need while trying to achieve their Investment goals.

See also: Track to the Future – with Mirabaud AM’s Liisa Juntunen

We carry out extensive value assessments across our products and services and make these available on our website for all to see. I would like to think that in addition to these quantitative measures, my team of sales professionals are the added qualitative value, working alongside advisers to build genuine long-term relationships rather than transactional arrangements. We are well aware advisers have many products and suppliers to choose from. We want to be the provider of choice to advisers, but we know we have to earn that privilege.

How much of your distribution is currently oriented towards climate change, net zero, biodiversity and other segments of sustainable investing? How do you see this approach to investing evolving?

Throughout our history, we have built a long track record of investing responsibly on behalf of our clients, as we believe this is the best way to achieve enduring value over the long term. ESG is fully integrated into all our investment processes. In terms of products and investment solutions: we cater for clients with no particular sustainability mandate, through those with specific ethical restrictions, such as our extensive charity client base. The common denominator of all our clients is that they seek solid risk-adjusted returns within the given mandate.

Especially over the last year when we saw investment performance dominated by the stellar performance of the ‘Magnificent 7’, we saw a distinct cooling of the market’s obsession with ESG investing. However, it does remain a crucial area of advice. We believe the key to this is the discovery process and making sure that any recommended product aligns with the end client’s views. In our view, this should be more of a discussion than a binary question, given that most clients will have a view on these issues as long as they are given the chance to express their views and have been given all the facts.

We also believe an active management approach is required when tackling these issues. As such, responsibly focused products in all its forms are definitely part of our distribution strategy, alongside our unconstrained products.

Sustainability Disclosure Requirements (SDR) is a game-changer in this space. We think it will enable clients and advisers to have confidence in the products and services offered in this area.

How are you now balancing face-to-face and virtual distribution? In a similar vein, how are you balancing working from home and in the office?

The number of face-to-face meetings and events has increased significantly over the last 12 months but is not yet back to pre-pandemic levels. It is easier, quicker and more sustainable to maintain an existing relationship virtually, but less effective when meeting someone for the first time as you do not get the same physical feedback. Through the move to more passive investing and consolidation in the market, there may be less need for a large distribution function in the future. However, the service you receive from an attentive, knowledgeable and helpful account manager is often a key differentiator for clients, and this is what we strive to offer.

See also: Track to the Future – with J. Safra Sarasin’s David Miles

The pandemic accelerated virtual communication so all of my team have all the technology at home and in the office to fulfil their roles and support advisers. Given the majority of my team are regionally based, communication has always been crucial, so no one feels isolated and unsupported. While we would like to see each other in person every day, the cost would be prohibitive it would not be very sustainable. This hybrid way of working meets our needs, and I do not think it will change in the foreseeable future.

What do you do outside of work?

Family and sport have always been an important part of my life. I have enjoyed many years playing rugby, cricket and now golf which is a great release from the pressures of work. My wife will probably disagree, but it is important for me to decompress through sport to recharge the batteries to start the week refreshed!

What is the most extraordinary thing you have seen?

Other than the birth of my two children, my wife and I were lucky enough to do some whale watching in Monterey, California, getting close enough to see the intelligence in the eyes of a couple of inquisitive humpbacks – extraordinary.

 Looking a little further ahead, in what ways do you see the asset management sector evolving over the next few years?

There will definitely be challenges to overcome, AI is a threat to jobs in finance generally but has particular challenges for asset management. Most people would agree that the fund market is oversupplied, so I expect consolidation in that area. However, people still need financial advice and someone to help them achieve their financial goals, so I see wealth management as a resilient area. Passive investing will continue to make gains, but truly active managers where value can be demonstrated have a place as well.

The conventional UK investor has typically opted to allocate their exposure to EMD into blended strategies, which invest in a combination of the three subcategories. By investing with an active EMD manager within the blended space, investors try to benefit from the expertise of investment managers who tactically move portfolio exposures across the different subcategories as market conditions evolve, optimising the risk and return characteristics of the portfolios.

Nevertheless, EMD funds have not historically been favoured by the conventional UK investor, who prefers to dedicate their fixed- income allocation to more traditional and core strategies, such as government bonds and investment grade corporate bonds. The combination of political risk, default risk, liquidity risk and in some cases also currency risk, makes EMD a volatile asset class, and therefore outside the consideration of the defensive characteristics typically required for fixed income allocations.

See also: BNP Paribas names head of emerging market debt

The asset class remains therefore a specialist sector, home to more sophisticated clients such as institutional investors and family offices. The demand for emerging markets has slowed during the past two years, with significant outflows in the retail market.

The asset managers have also reduced the number of launches of new funds in the sector for the UK retail market over the same period, with the number of EMD funds across the Investment Association sectors increasing by only two funds. It stands at a total of 121, as of the end of March 2024.

Read Eduardo Sánchez’s funds to watch by assets under management, three-year performance and newcomers in May’s Portfolio Adviser magazine

Bond yields have been pushed up to their highest levels in almost a decade, but the widely-anticipated interest rate hikes from central banks later this year could drag them down to more modest levels.

As such, most UK asset owners are scrambling to lock into yields at historic highs, with half (51%) extending the duration of their existing bond portfolios.

Ed Harrold, fixed income investment director at Capital Group, said: “As monetary policy inflection nears, high quality bonds are becoming increasingly attractive.

“With yields near decade highs, UK bond investors have a rare opportunity to strengthen their defensive allocations and secure attractive yields.”

See also: Nordea AM launches two Article 9 bond funds

Investors are also taking more risk in the bonds they are buying, with 28% increasing credit risk over the coming year. A lesser 15% plan to be more risk-averse in their fixed income buying.

A unifying consensus among bond buyers was that active strategies offered the best exposure, with 83% agreeing that active funds were the best approach for investing in high-yield credit.

Demand for fixed income ahead of potential rate hikes may be high, but UK asset owners displayed more interest in the US and Europe than their home market.

Investment grade corporate credit was at the top of investors’ shopping lists, predominantly in the US (37%), followed by the eurozone (34%), and lastly in the UK (23%).

See also: Is the landscape finally changing for commodities?

The upbeat note on which emerging market debt entered the year continues to prevail. But while tailwinds exist, there are a myriad of potential risks to navigate in the coming months.

Improving prospects for global economic growth, coupled with the Federal Reserve likely being at or near peak rates, have buoyed sentiment across EM debt.

Spreads continue to grind tighter across sovereigns and corporates and while the aforementioned factors are certainly reasons for optimism, the significant tightening in spreads is also evident among weaker EM regions and credits.

This widespread rally, when viewed in the context of what appears to be a challenging last mile in the global battle against inflation, ongoing wars in Europe and the Middle East, and elevated political uncertainty around the world, begs the question – are markets getting ahead of themselves?

A supportive backdrop, but persistent risks

With the US economy growing, China’s weakness appearing to have found a bottom, and the rest of Asia continuing to gain strength, sovereign hard currency debt remains on solid fundamental footing as recession concerns ebb.

In particular, the strength of the US economy benefits countries in South and Central America and the Caribbean given the multiple linkages between them from trade to tourism.

The technical picture also remains supportive for EM debt, with institutional investment flows in EM turning positive in 2023 following a year of outflows. Outflows were dominated by retail funds last year, but developed market commercial banks increased their exposure to the asset class. Historically, smart money inflows have been a leading indicator of overall investor inflows into EM debt.

However, the overall picture is also one of a number of potentially significant risks. There is the possibility for further escalation in the Russia-Ukraine war – which could have a contagion effect on neighbouring countries – as well as elevated political risk given the number of elections around the world this year.

On the positive side, many EM election outcomes are priced into the market and therefore unlikely to result in any major disruptions. Perhaps counterintuitively, the US presidential election may be the one most likely to introduce volatility to the EM market – if Donald Trump returns to office, a number of major international policies could be called into question.  

In this environment, we see value in investment grade (IG) sovereigns with solid fundamentals, particularly in BBB countries such as Mexico, Uruguay, Bahamas, and Indonesia.

Select opportunities also remain in the high yield space, especially where spreads continue to offer a healthy overcompensation for default risk. Specifically, we see value in high-quality BB sovereigns such as Dominican Republic, Costa Rica, Jamaica, Paraguay, and parts of Eastern European.

In the local debt space, we are less constructive on local interest rates because we expect to see fewer and smaller cuts from EM central banks going forward. However, there are a few EM countries that still have room to cut, such as Mexico and some Central and Eastern European nations.

The growing opportunities in IG and select HY

Spreads in the EM corporate market continue to tighten in tandem with other markets and are approaching post-crisis tights. However, absolute yield levels look attractive relative to many other fixed income asset classes.

While there are potential significant risks on the horizon that could derail this tightening and drive spreads wider — which provides a reason to advocate for some degree of defensiveness — we also see tailwinds supporting the market.

In particular, funds are being reallocated from money market funds into developed market investment grade (IG) asset classes, which is providing crossover demand tailwinds for select segments of EM corporates.

Specifically, we see EM IG corporates (which constitute roughly 60% of the EM corporate debt universe) as the segment that is not only benefitting from demand tailwinds, but is also likely to benefit from potentially attractive convexity when the Fed starts to cut rates.

We also see value in select idiosyncratic opportunities in the high yield space, as the segment is likely to benefit if economic data continues to point toward a ‘no landing’ scenario and sentiment improves for riskier debt. In addition, corporate fundamentals overall remain sound for both IG and HY companies.

From a sector perspective, we remain cautious around sectors which have been impacted by the lower cost product exports from China such as petrochemicals and steel.

We also see some technology, media, and telecommunications companies challenged with the aftermath of higher funding costs, the capital expenditure overhang from previous years, and a reduced ability to pass through costs to consumers.

A cloudy crystal ball

While current conditions remain favorable for EM debt overall, the potential for disruption exists across many fronts – and either political or geopolitical events could pose risks for EM assets going forward.

Despite the riskier backdrop, we believe the diversity within EM sovereign, corporate and local debt provides a breadth of opportunities across issuers and regions which have unique performance drivers.

In our view, rigorous, bottom-up credit and country selection, combined with active and discriminating management, remain paramount to managing the risks across the market, as well as to identifying the issuers that are well-positioned to navigate the uncertain environment.

And investors would appear to have recognised the opportunity. According to fund tracker EPFR, a record $22.8bn (£18.2bn) has flowed into US corporate bond markets over the year to date – the strongest annual start in five years. In the UK, corporate bonds were the second best-selling retail sector in January (after money market funds).

That said, fixed income performance since the start of the year has been relatively weak, suggesting the outlook may be more nuanced, and there are a range of factors that could destabilise bond markets in the near term. First and foremost is shifting expectations on interest rates. At the start of the year, it became increasingly clear the expectations for rate cuts in 2024 were too high. Government bond yields had fallen too far, given the likely trajectory of inflation.

“This caused a huge amount of easing in financial conditions,” says James Ringer, a fixed income portfolio manager at Schroders.

“This is one of the better leading indicators of where growth will follow and the impact can be relatively swift. We came into 2024 revising down the probability of a hard landing significantly and started revising up the probability of no landing.” This re-adjustment of rate expectations has been a major driver of the weakness in bond markets since the start of the year.

US debt levels

While that adjustment is now complete, there are other factors that may exert a longer-term influence on fixed-income markets. The level of US debt, for example, is a risk factor. The US fiscal deficit in 2023 was $1.7trn, an increase of $320bn from the previous fiscal year. For the year to date, the Federal government has spent $828bn more than it has collected in taxes. On current rates, the government will be spending one-third of its income on debt interest by 2030.

On most measures, this looks unsustainable – yet neither presidential candidate appears inclined to tackle it. Donald Trump is pushing for tax cuts, while Joe Biden would like more spending. Historically, the US government has been able to rely on a range of buyers for its debt, but some of these natural buyers are evaporating. At the same time, the US Federal Reserve has withdrawn support for fixed-income markets through its quantitative tightening programme – now manifesting as strains in the reverse repo market.

Historically, as and when domestic interest went cold, the US could rely on international buyers to absorb its debt – but there have been changes here as well. The Japanese, for example, have been strong buyers of US debt but, as the Bank of Japan raises domestic interest rates, there are signs they are turning back to their local market. There are also risks around geopolitics – China has historically been a significant buyer of US debt, but deteriorating relations between the two sides makes this less likely.

The real question, of course, is not whether there are buyers for US debt so much as the price they are willing to pay. Phillip Swagel, director of the Congressional Budget Office, has suggested the mounting US fiscal burden is on an “unprecedented” trajectory, risking a crisis akin to the Liz Truss/Kwasi Kwarteng moment in the UK.

While there has been plenty of speculation, however, such a crisis would not appear imminent. Spending on largescale infrastructure and green energy projects will ease, and the US may end up issuing a smaller amount of net debt than last year.

Furthermore, if there are any signs of strain in the market, the Federal Reserve is likely to slow its quantitative tightening programme, which would slow the supply of US treasuries hitting the market. Money market funds are also likely to be a significant source of demand so this should remain a risk about which investors need to be vigilant, rather than a source of immediate problems.

Read the rest of this article in the April issue of Portfolio Adviser magazine